But while the challenge of finding the right provider is great,
so is the potential performance improvement and ease of administration that an
OCIO can bring to pension plan clients, Klotter noted in a recent webinar
hosted by Strategic Investment Group. Klotter and other experts predict substantial
growth in OCIO mandates, and during the webinar, touched on a variety of key
opportunities and challenges in the budding industry, especially among
corporate defined benefit (DB) plans and not-for-profit endowments and foundations
(see “OCIO Channel Gaining Steam”).

For those conducting a first-time OCIO search, Klotter
suggested the first step will be to define which model of service to pursue.
There are generally considered to be three segments to the OCIO market, he
explained, representing “centralized,” “hybrid,” and “decentralized” mandates.

The centralized model involves an OCIO team that runs an
investment pool into which a pension plan can transfer some or all of its
assets, Klotter said. The investment pool will be managed according to a set of
parameters defined in advance by the OCIO provider to meet the needs of a
specific set of clients—so in this sense there is less customization via the centralized OCIO approach than one might
expect, Klotter noted.

“Under the centralized model, really the OCIO is running a
master fund into which the client chooses to move some or all of its funds,”
he explained. “In a sense this is the simplest arrangement for OCIO
services, but there is less opportunity for customized mandates.”

When
considering centralized OCIOs, Klotter urged pension plan fiduciaries to
closely review the performance of the funds into which their assets will
actually be commingled. Oftentimes centralized OCIO providers will use data from
closed funds to market strong performance, he noted, but that data will not necessarily tell a
corporate pension plan client how the OCIO is doing on the funds into which its assets will actually be added.

“To get around this, you can ask for things like returns by
asset class, and related to that, how are the asset classes actually defined?”
Klotter explained. “Also critically important is how legacy assets will be
treated in a transfer to the OCIO’s master fund of funds. Only very rarely does
a client come to an OCIO provider with a big bucket of cash. More often assets
will need to be transferred, so that’s an important consideration as well.”

The decentralized model, on the other hand, represents what most
pension plan sponsors probably picture when they think about OCIOs, Klotter
noted. Often more complex and more expensive, decentralized OCIO offerings are specifically tailored to each client.

“Under the decentralized model, each policy for each client
is being fully developed and customized,” Klotter said. “While the objectives
for the OCIO relationship can be customized, potentially leading to better
outcomes, this type of mandate is the hardest to report on and assess.”

The main challenge in assessing decentralized OCIO service
providers is that they strive to serve each customer differently. Each pension plan
has a different list of assets and liabilities on the balance sheet, Klotter
explained, so each will seek different services and outcomes from an
OCIO. This makes it exceedingly challenging to assess how past performance data for one client will translate
to another plan’s current, individual needs.

“It’s key for the plan committee to study how providers do
with different types of client objectives,” he said. “And of course you'll have to define what components of the provider’s
services are you going to access. Does the OCIO provider truly provide
additional value in the areas you are seeking?”

The
hybrid model, in turn, stands at some point between centralized and
decentralized OCIO arrangement, Klotter continued. Hybrid mandates will require
examination similar to both centralized and decentralized offerings.

Regardless of the service approach a pension plan committee
is considering, Klotter warned of several red flags that should be watched for during the OCIO provider search. First and foremost is unwillingness
or inability to share real performance data.

“In any manager search one should be careful when looking at
simulated and hypothetical data, but this is especially important in the OCIO
world,” Klotter said. “Actual returns are almost always better to look at, even
if they are not lined up exactly with your plan’s own unique objectives.”

Another important takeaway, Klotter said, is “read the
footnotes.”

“Oftentimes I’m asked, ‘What is the most common mistake you
see in the OCIO search?’” Klotter explained. “My answer is always that people
too often skip reading the footnotes and the fine print. If you look at some of
the reporting you get out of an OCIO provider, there’s a wealth of information
in the footnotes, and it can be really surprising what’s in there.”

One distinct danger in the OCIO industry is its immaturity,
Klotter said. “The OCIO industry is still young,” he explained, “so you never
know how movement of staff and resources will impact your relationship with a
given OCIO provider. Is it possible that the movement of people could impact the
return series you are getting? You should know this.”

In concluding the webinar, Klotter warned retirement plan
committees that it’s better to understand three or four OCIO firms well rather
than understand only a little about 10 providers. Best practices are still being defined for the OCIO-pension plan relationship, he added, so it's important to be aware of what other clients are seeking and receiving from OCIOs.

“It’s
absolutely critical that you conduct a deep search for an OCIO,” he noted. “This
means a deep dive on the investment performance for a select group of providers
you have researched. Don’t be shy about asking for data. If they aren’t willing
to give data—that’s a clear indicator in itself. Maybe they’ll ask you to sign
a nondisclosure agreement, and that’s fine, but you should be able to get the access you need.”